Prices on the exchange aren’t exactly stable: prices go down and up at a fast pace. When you trade a lot of stocks or on a certain market, this may result in a few losses. The return isn’t what you expected it to be. By buying put options you can limit your losses without having to sell any stock to achieve that same damage control.
Benefits of options
If you don’t use options and you expect a significant drop in price, then it’s necessary to sell some inventory from your portfolio. As soon as the exchange is doing well again, you will need to buy all of your stocks again. The only party that wins if you do this is the broker. By using put options to protect your wallet against an expected downtrend, you save a lot of money on transaction fees!
Buying a put option
Let’s say the UK 100 is set at 6000 points and you expect a massive drop to 5900 points. This isn’t too good, as you have a lot of United Kingdom stocks in your portfolio. With put options this isn’t a problem at all. By using a put option you benefit from a downtrend, meaning every decrease in price means profit for you.
Buy a put option with a low issue price around the expected turning point (in this case 270 points). If the prices really go down, you will receive a lot of money because you get the drop in price. After this turning point, the prices will probably go up again and your portfolio will not be harmed by this sudden downturn in the market.
Obviously, you could have been wrong and let’s say the prices actually go up. You then pay a fee for the option, which will be the same as your loss; the option isn’t usable anymore. No problem. You expected a decrease and you insured yourself using an option. If the prices do go up, your profits do too because you still have those stocks in your portfolio!